Warrants are a little bit like a living memory of a long-past era of finance. Although relatively uncommon and out of favor in the United States, warrants have remained more popular in other areas of the world, such as Hong Kong. However, they do still appear in the U.S. markets, and investors should know how to assess and value them.Warrants can be a high-return investment tool. A warrant is like an option. It gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. It is unlike an option in that a warrant is issued by a company, whereas an option is an instrument of the stock exchange. The security represented in the warrant (usually share equity) is delivered by the issuing company instead of by an investor holding the shares.

Companies will often include warrants as part of a new-issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, provided the underlying value of the security actually does increase over time. (Warrants are just one type of equity derivative. Find out about the others in 5 Equity Derivatives And How They Work.)

Types of WarrantsThere are two categories of warrants: a call warrant and a put warrant. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date.

Although there are several kinds of warrants, the most common types are detachable and naked. Detachable warrants are issued in conjunction with other securities (like bonds or preferred stock) and may be traded separately from them. Naked warrants are issued as is and without any accompanying securities.

Other less common types of warrants include wedded warrants (which can only be exercised if the attached bond/preferred stock is surrendered) and covered warrants (which are often issued by financial institutions and rarely issued by the underlying company). Companies will also occasionally issue put warrants to hedge employee option programs.

Characteristics of a Warrant Warrant certificates have stated particulars regarding the investment tool they represent. All warrants have a specified expiry date, the last day the rights of a warrant can be executed. Warrants are classified by their exercise style: an American warrant, for instance, can be exercised anytime before or on the stated expiry date, and a European warrant, on the other hand, can be carried out only on the day of expiration.

The underlying instrument the warrant represents is also stated on warrant certificates. A warrant typically corresponds to a specific number of shares, but it can also represent a commodity, index or a currency.

The exercise or strike price is the amount that must be paid in order to either buy the call warrant or sell the put warrant. The payment of the strike price results in a transfer of the specified amount of the underlying instrument.

The conversion ratio is the number of warrants needed in order to buy (or sell) one investment unit. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means that the holder needs three warrants in order to purchase one share. Usually, if the conversion ratio is high, the price of the share will be low, and vice versa.

In the case of an index warrant, an index multiplier would be stated instead. This figure would be used to determine the amount payable to the holder upon the exercise date.

Investing in Warrants Warrants are transferable, quoted certificates, and they tend to be more attractive for medium-term to long-term investment plans. Because they tend to be high-risk, high-return investment tools that remain largely unexploited in investment strategies, warrants are also an attractive option for speculators and hedgers. Transparency is high, and warrants offer a viable option for private investors as well. This is because the cost of a warrant is commonly low, and the initial investment needed to command a large amount of equity is actually quite small.

AdvantagesLet's look at an example that illustrates one of the potential benefits of warrants. Say that XYZ shares are currently priced on the market for $1.50 per share. In order to purchase 1,000 shares, an investor would need $1,500. However, if the investor opted to buy a warrant (representing one share) that was going for $0.50 per warrant, he or she would be in possession of 3,000 shares using the same $1,500.

Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains and losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will vary significantly because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change.

Here's another example to illustrate these points. Say that share XYZ gains $0.30 per share from $1.50, to close at $1.80. The percentage gain would be 20%. However, with a $0.30 gain in the warrant, from $0.50 to $0.80, the percentage gain would be 60%.

In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: $1.50 / $0.50 = 3. The "3" is the gearing factor - essentially the amount of financial leverage the warrant offers. The higher the number is, the larger the potential for capital gains (or losses).

Warrants can offer significant gains to an investor during a bull market. They can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realize as much loss because the price, in relation to the actual share, is already low. (Leverage can be a good thing, up to a point. Learn more in The Leverage Cliff: Watch Your Step.)

DisadvantagesLike any other type of investment, warrants also have their drawbacks and risks. As mentioned above, the leverage and gearing warrants offer can be high. But these can also work to the disadvantage of the investor. If we reverse the outcome of the example from above and realize a drop in absolute price by $0.30, the percentage loss for the share price would be 20%, while the loss on the warrant would be 60% - obvious when you consider the factor of three used to leverage, but a different matter when it bites a hole in your portfolio.

Another disadvantage and risk to the warrant investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value.

Finally, a holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made.

A Bittersweet Stock JumpOne notable instance in which warrants made a big difference to the company and investors took place in the early 1980s when the Chrysler Corporation received governmentally guaranteed loans totaling approximately $1.2 billion. Chrysler used warrants - 14.4 million of them - to "sweeten" the deal for the government and solidify the loans.

Because these loans would keep the auto giant from bankruptcy, management showed little hesitation issuing what they thought was a purely superficial bonus that would never be cashed in. At the time of issuance Chrysler stock was hovering around $5, so issuing warrants with an exercise price of $13 did not seem like a bad idea. However, the warrants ended up costing Chrysler approximately $311 million, as their stock shot up to nearly $30. For the federal government, this "cherry on top" turned quite profitable, but for Chrysler it was an expensive afterthought.

Valuing Warrants with the Black-Scholes ModelAlthough there are several possible methods for valuing a warrant, a modified version of the Black-Scholes model is most common. This formula is for European-style options and, though American-style options are theoretically worth more, there is not much difference in price in practice.

In the Black-Scholes model, the valuation of a call option is expressed as:

C = S N(d1) - X e-rT N(d2)

Where:

C = price of the call option

S = price of the underlying stock

X = option exercise price

r = risk-free rate

T = time until expiration

N() = area under the normal curve

d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2

d2 = d1 - σ T1/2

Because of the dilution that warrants represent, the value of that call needs to be divided by (1 + q) where q is the ratio of warrants to outstanding shares, assuming each warrant is worth one share.

The Factors That Influence Warrant PricesBeyond the calculation above, investors should consider the following factors when evaluating the price of a warrant.

Underlying Security PriceThe higher the price of the underlying security, the more valuable the warrant becomes. After all, if the price of the stock is below the strike price of the warrant, there is no reason to exercise the warrant because it is cheaper to buy the stock on the open market.

Days to MaturityGenerally speaking, options and warrants are worth less as time goes on and expiration approaches. This phenomenon is also called "time decay," and it will accelerate as expiration approaches if the strike price is above the current price.

DividendWarrant-holders are not entitled to receive dividends, and the corresponding reduction in the stock price reduces the value of the warrant.

Implied VolatilityThe higher the volatility, the higher the odds that the warrant will eventually be in the money and the higher the value of the warrant will be.

Additional FactorsIn addition to those factors that are common between options and warrants, warrants have a few extra factors of their own:

Dilution: Because the exercise of a warrant will increase a company's outstanding shares, this dilution adds a twist to valuation that is not present in normal option valuation.

Premium: Warrants can be issued at premiums; the lower the premium the more valuable the warrant.

Gearing/leverage:Gearing is the ratio of the share price to the warrant premium, and it reflects how much the price of the warrant changes for a given change in the stock. The higher the gearing is, the more valuable the warrant.

Restrictions on exercise: Though very difficult to quantify mathematically, any restrictions on the exercise of warrants will impact the value of a warrant, typically negatively. A common restriction (and one that is easy to quantify) is the difference between American-style and European-style warrants; American-style warrants permit exercise at any time, while European-style warrants can only be exercised on the expiration date.

The Bottom LineAlthough warrants are not very common any more, they are not all that hard to value in practice. After all, a warrant is basically just a long-term option issued by a company. Investors need to make a few adjustments for unique factors like dilution, but a basic Black-Scholes options pricing formula will produce a reasonable assessment of the warrant's value. Warrants can offer a smart addition to an investor's portfolio, but warrant investors need to be attentive to market movements due to their risky nature.(To learn more, read Investing In Warrants and How Are Stock Warrants Different From Stock Options?)